Calculating ROI is an important part of evaluating the health of not only your company but also your IT department.
When the CIO assesses the ROI for a new business process, the costs of all related implementation activities must be examined. The CIO must consider an analysis of any organizational development costs that will be incurred as the corporation implements any required changes. If a CIO waits too long to complete a thorough analysis of ROI in order to change business processes to match the capabilities of competitors, then the implementation of a new business process may simply slow a reduction in profits rather than generate increases.
In any case, it’s important for the CIO to be aggressive in calculating the projected cost of changes in personnel, unplanned purchases, or new technologies that change the way the company does business.
Although it is one of the most commonly used tools of IT and accounting, financial statement analysis is also one the most misunderstood and error-prone tools available. Generally, the use of ratios allows the CIO to develop a set of statistics that reveals key financial characteristics of the organization under scrutiny.
According to VentureLine.com’s glossary, “Ratio Analysis involves conversion of financial numbers for a firm into ratios. Ratios allow comparison of one firm to another. Since ratios look at relationships inside the firm, a firm of one size can be directly compared to a second firm (or a collection of firms) which may be larger or smaller or even in a different business. Financial Ratios are a method of comparison not dependent on the size of either firm. Financial Ratios provide a broader basis for comparison than do raw numbers.”
In almost all cases, ratios are used in two major ways:
- Ratios for the organization in question are compared with industry standards. These industry standards may be obtained through Dun & Bradstreet , Robert Morris Associates, or trade associations. To avoid major mistakes, care must be taken to compare the company under analysis to standards developed for companies in the same industry and of approximately the same asset size.
- Ratios are used to compare the trend over time for a particular company. For example, the trend of the after-tax profit margin for the company may be compared over a five-or-ten year period.
Financial ratio categories
Key financial ratios are commonly grouped into four major categories, according to the particular aspect of the company’s financial position that the CIO is attempting to highlight.
- Profitability. “Bottom line” ratios are designed to measure the earning power and profitability record of the corporation. The three most common are return on sales, return on investment (ROI), and return on equity.
- Liquidity. These ratios are designed to measure the ability of the corporation to meet its short-term liabilities as they come due.
- Operating efficiency. These ratios are measures of the efficiency with which corporate resources are employed to earn a profit.
- Capital structure (leverage). These ratios are measures of the extent to which the corporation employs debt financing.
Ratio analysis is more art than science. Great care must be exercised by the CIO in translating data from financial statements into information that is useful for informed decision making. In order to translate data effectively, you must:
- Understand the numbers.
- Assure the accuracy and applicability of the database utilized for financial forecasting.
The overriding objective is informed decision making.
DuPont system of financial analysis
The DuPont system of financial analysis is the most commonly used system because it is the first to take multiple factors into the equation, and it gives the most balanced results. But remember: This is a field that will argue that if one foot is in a bucket of boiling water and the other foot is encased in a bucket of ice, then, on average, the person is comfortable. Even the best analysis can’t account for everything.
This method received its name in recognition of DuPont Corp., which first developed it. The approach establishes several financial ratios and demonstrates how these ratios interact to determine the profitability of an investment. The method can be used for analyzing the financial situation for every different forecast that has been made. It presents a fluid simulation model that shows how the return on investment will change in response to other variables.
Assumptions and risk
Projecting the financial results of a corporation requires certain assumptions by the CFO and CIO about market and cost behavior. Every assumption reflects a degree of uncertainty and risk. To arrive at an explicit appreciation of the risk factor facing the CIO in a financial analysis, the CIO must calculate the degree of probability associated with each important variable, such as the expected market potential, the selling price, and the operating costs.
Key factors to be considered include:
- Market size
- Selling price
- Market growth rate
- Eventual share of market
- Total investment required
- Useful life of facilities
- Residual value
- Operating costs
- Fixed costs
Using the DuPont method
One particular value is selected at random for each of the nine factors above. The rate of return on investment is then calculated for the combination. This process is repeated until all sets of these factors have been exhausted. The result gives the range of the rates of return and the probability of achieving them for the totality of sets of input factors.
General Web site information
- Almanac of Business and Industrial Financial Ratios 2000 by Leo Troy, published byPrentice Hall
- ROI Planning for Profitable Growth , published by Alexander Hamilton Institute
- Multi-Criteria Decision Analysis Via Ratio and Difference Judgement by Freerk A. Lootsma, published by Kluwer Academic Publishing
Jack Fox is Executive Director of The Accounting Guild in Las Vegas. Fox has been assisting thousands of accountants and IT consultants in building their own successful businesses. He also coaches for effective leadership in IT functions of small to medium-size enterprises since 1984. He is the author of five books, including the third edition of Starting and Building Your Own Accounting Business , published by John Wiley & Sons.
Do you spend half your time making a budget, only to readjust again a month later? Can you make sense out of the spreadsheets that your accounting department is constantly sending you? What’s the best way to calculate ROI or TCO? If you have an accounting conundrum that you’d like answered or explained, send your question to Ask Jack. Every month, Jack Fox will answer questions from savvy CIOs who just don’t have time to become experts in bean counting.